In-Depth Analysis: War in Ukraine Creates Uncertainties for Leveraged Debt Investors
Investors are notoriously averse to uncertainty, and Russia’s invasion of Ukraine has created an abundance of uncertainty in financial markets.
Even risks and undesirable circumstances that may seem far removed from the leveraged and high-yield lending segments may, in fact, have unexpected interrelationships that can affect debt markets. What are some of the uncertainties and how might they affect leveraged debt investors in the coming months?
Of course, there is no way to fully know the ripple effect of the sanctions and restrictions imposed on Russia and its wealthiest citizens. A hedge fund manager cited, as an example, the combination of a falling rouble, while Russians cannot access their assets, which could trigger a series of cascading events, perhaps a margin call that produces a hard sell, hammers prices, impacts other investors’ portfolios, forcing them into margin calls, etc.
Uncertainties and unknowns
The high yield market did not exist the last time the world saw a land war between two European nations. And the last time inflation was this high, today’s oldest analysts and portfolio managers were just getting started, while the youngest on Wall Street might not even have been born.
With little or no experience to draw on, the investment community is likely to encounter completely unexpected and totally unquantifiable circumstances. Uncertainties can be assessed, modeled and priced. But for the hedge fund manager quoted earlier, what concerns most are the unknown unknowns of this war (a term Secretary of Defense Donald Rumsfeld made famous in 2002). These are risks and potential outcomes that aren’t even on anyone’s list.
Debt markets, of course, use interest rates to price uncertainties and unknowns. The Russian invasion has, at least for now, halted the rise in US 10-year Treasury yields, which hit 2.05% in mid-February. Since then, 10-year yields have fallen 35 basis points, then retraced part of the decline following Fed Chairman Jerome Powell’s March 2 hearing before the Financial Services Committee. of the United States House of Representatives. They continue to oscillate.
The 10-year excursion above 2.0% was driven by a combination of inflation rising faster than at any time since the early 1980s, with the Fed telegraphing a hike in fed funds rates in March after admitting that inflation was not quite transitory, and the economy showing signs of overheating, with seemingly full employment and jobs begging.
But while the sudden drop in yields has been widely reported as a flight to quality, it may also have a more worrisome cause. Peter Cecchini, director of research at Axonic Capital, notes that the southward movement in 10-year yields may also be a warning that the US economy – if not the world’s – is rapidly slowing. He points out that the spread between 2-year and 10-year US Treasuries is now 23 basis points, down from around 150 basis points last spring. Each time since 1980 that the 2-year/10-year spread has reached zero or less, a US recession has quickly followed. We are again close to this line.
Source: St. Louis Fed
Cecchini says even without higher interest rates, inflation will be sand in the wheels of the economy. On its own, it will eventually hurt corporate margins and profits, weaken consumer spending, and dilute the impact of rising wages, which could eventually slow GDP growth and potentially even trigger a recession.
Then there is oil, which is now trading above $120 a barrel. This alone is a significant driver of inflation, a factor which, if increased much further, may be more like a crowbar in the gears of the economy than sand. Cecchini adds that unless we encounter a repeat of stagflation, the inflation-induced slowdown itself may reduce inflation and, in effect, inflation will have died out.
Another unknown facing investors (a known unknown in Rumsfeld’s lexicon) is the impact the current environment may have on the relationship between returns and valuations. Basic trading math (as well as valuation methodologies such as the Fed model) indicated that until recently falling yields should dictate higher stock valuations as future cash flows are discounted at lower rates.
With the 10yr well past its pandemic low, short rates rising and the fed funds rate on the verge of falling to zero, the same calculations that drove multiples soaring should now steer investors’ expectations towards higher levels. multiples below. This change in expectations may have played a role in the declines in equity indices since the end of 2021. But with the decline in the 10-year rate, should multiples resume their upward march? This is another uncertainty.
On the federal funds rate, if the Fed only increases 25 basis points or not at all, will it take that action because it thinks the economy doesn’t need more, that the war will slow down inflation by itself, or that, for whatever reason, inflation will not last much longer? Wars are usually inflationary, and with this one impacting supply chains, that might be especially true now.
Or would a 25 basis point rise – or no rise at all – indicate a resumption of the “Fed put” on which stocks have depended, to one degree or another, since the days of Alan Greenspan. Again, the answer is uncertain.
Change of leveraged loan
Rising yields have also pushed high-yield investors away from fixed-coupon debt toward the floating-rate leveraged loan market, whose assets under management skyrocketed in the first quarter of 2022. Meanwhile, speculative-grade bond issuance has fallen sharply from its record pace of the past two years.
Despite their relatively safer position at the top of capital structures, the issues underlying the S&P/LSTA Leveraged Loan Index lost 0.54% through March 7 of this year. Although their losses are smaller than those of high yield (the ICE/BofA US High Yield Index is down 4.5% since the start of the year) and tiny compared to those of equities (the S&P 500 and the Nasdaq are down 11.9% and 18.0%, respectively, year-to-date), the performance of loans can be attributed, at least in part, to a general tendency of investors to adopt an attitude of risk aversion.
But now, with leveraged loans in the loss column and 10-year yields falling, it is possible that high-yield bonds will once again become attractive relative to leveraged loans.
In recent conversations, leveraged debt traders have pointed out to LCD that Russia’s share of global GDP is around 1.8% and Ukraine’s is around one-tenth, which may not be enough to have a noticeable effect on most US businesses (according to World Bank GDP data).
But this argument ignores side effects, including Russia’s role in raw materials. Russia and Ukraine together export around 25% of the world’s wheat, while Russia produces more than 10% of the world’s oil and holds the largest natural gas reserves in the world, around 20% of the planet’s total. The Russian company Rusal produces around 6% of the world’s aluminium.
Clearly, despite the relative size of its GDP, Russia can unilaterally harm the global economy if it chooses. But even if Russian President Vladimir Putin does not weaponize the country’s raw materials, investors cannot ignore the psychological impact war could have on consumer spending. Worried consumers are spending less, and this war is giving consumers a lot of worries. The list stretches from Russian commodities and soaring gas prices, to relatives living in Ukraine, Russia and even Europe, and extends to nuclear power generation and nuclear weapons.
Much has been made of the potential impact of war on global supply chains. A direct line has repeatedly been drawn between global logistical difficulties and inflation, and if these difficulties worsen, inflation could do the same. But if inflation is going to get worse, why are yields falling? Does the government bond market think it knows anything about the Fed’s or Putin’s intentions?
Opportunities in difficulty
Investors’ swing into risk aversion and the resulting drop in debt prices means that struggling investors now have a longer menu than just a month ago. For an imperfect frame of reference, using the traditional hurdle that distress begins at 1,000 basis points of the curve, the S&P US High Yield Corporate Bond Index as of February 1 contained 46 bonds trading at distress levels (34 transmitters). A month later, on March 3, he held 57 bonds (42 issuers) trading at over 1,000 basis points.
Conversations with leveraged debt traders and analysts have highlighted the issues and opportunities facing investors. Most firms on the sell side will not trade Russian sovereign debt, although some will trade its corporate papers, and most will trade Ukrainian sovereign and corporate issues.
According to traders, names of Russian companies being talked about as being at least watched, if not bought, by struggling investors include Gazprom, Lukoil, VimpelCom, Credit Bank of Moscow, Rusal, Tinkoff Bank, State Transport Leasing Company, Ozon Holdings PLC, Yandex NV and EVRAZ plc.
The Ukrainian company name most commonly mentioned by traders is the agricultural products company MHP SE. But according to Stan Manoukian, an analyst at Independent Credit Research LLC, Ukrainian sovereign paper is the “number one topic”. Currently trading in the 20s with accrued interest, the bullish theory here, suggested by both Manoukian and traders, is that if Ukraine survives the war, a global financial entity such as the IMF or World Bank could step in. and maintain the country’s solvency. as it rebuilds.
Manoukian of Independent Credit envisions scenarios in which Ukraine survives as a sovereign entity. They include Putin succumbing to global pressure and stepping down, dividing Ukraine into a Russian eastern half and a democratic western half, and a negotiated settlement that leaves Ukraine somewhere between those outcomes.